I have been expecting a near-term bottom. We may have gotten it.
Unfortunately, it may not last.
The big news today was two-fold - first, that the government is considering a solution to the bad debt crisis by setting up a Resolution Trust Corporation-like entity to buy the banks' bad mortgage debt; and second, that the government is considering a ban on short sales.
The idea behind RTC II is probably a necessary one. America has a long history of the government bailing out the financial system and acting as a lender of last resort. The financial problems of the housing bubble are as massive as this country has seen, perhaps ever. It is no surprise, given the U.S. government has now become the largest mortgage company in the world via the nationalizations of the GSEs, one of the largest insurers in the world given its nationalization of AIG (AIG), and given that three-quarters of the Federal Reserve's balance sheet is now comprised of risky securities, that the government was going to step in in a big way to try to stop the rot.
The question now, is will it be successful?
If the idea is to stop the panic in the financial markets, the answer is probably "yes," but that answer is not unequivocal. This is now the fifth attempt by the U.S. government to address the meltdown of the housing bubble - slashing interest rates, bailing out Bear Stearns, extending the Fed's balance sheet to risky assets, the bailout of AIG, and now the creation of RTC II.
Each of the previous four actions have been more dramatic than the prior. Each failed.
Now, perhaps the government is going to be fifth time lucky. And simply because four prior attempts failed does not condemn the fifth to failure too.
But what if it does fail? What then?
The government is beginning to use very big bullets. It does not have many shots that do not lead to dangerous and destabilizing inflationary pressures in the future.
The proponents of RTC II argue that as RTC II takes bad loans off the books, capital will be freed so banks can start lending again. That may be, but there are two problems with this line of thinking.
First, home prices are still too high! The NAR affordability index has been falling this year.
click to enlarge
Despite falling home prices, incomes have been falling faster, thus making homes less affordable.
At around 6.5% for a qualifying mortgage, mortgages are currently not expensive. Increasing mortgage availability and/or lowering interest rates on mortgages as a solution to halting the decline in (over-valued) home prices is tantamount to lowering margin requirements and rates as a solution to falling stock prices during the unwinding of the tech bubble. More credit availability does not solve the problems of over-supply and over-valuation.
In fact, I will make the bold prediction that when the housing market bottoms, the country will be awash in liquidity, and getting a cheap mortgage will be no problem. We are far from that scenario yet.
More debt is not the answer because there is already too much debt. The consumer is undergoing a multi-year deleveraging process. The consumer simply has too much debt. The excess consumer debt is being worked down. The consumer will not collapse, but is impaired and will not be the driving force of the world economy as the American consumer has been for the past decade.
Within the financial system, the conduits of credit creation have been impaired. The securitization machine is not broken, but it is severely damaged. The aggregate financial system is going through a period of deleveraging. Balance sheets are broken at many financial companies and the focus going forward for the next several years will be to strengthen those balance sheets.
This makes 2008 very different from the early 1990s. Back then, neither leverage nor valuations ever got as high as it did this decade. This is a period of asset deflation and credit deleveraging as we unwind the excesses.
It is staggering to think how much money the government has thrown at this problem. Tallying up the loans given to companies, the facilities offered by the Fed to swap impaired assets for Treasuries, the tax rebates and the reported $500 billion the government is apparently going to commit to RTC II, well over $1 trillion will have been thrown at the problem.
Yet, I am not convinced any of this will halt the inevitable. Housing prices must continue to fall. If they do not, home inventories will remain high, the market for credit will not be allowed to clear, as banks delay writing down loans, and we could find ourselves in a Japan-style sclerotic environment. The problem is so large, the edifice is most likely to continue falling on itself.
And like Japan, the current environment is very deflationary. Falling asset prices and contracting credit is evidence of a deflationary environment.
Thus, the tell for the success of the government actions may be the gold price. I had written off gold, thinking that the multi-year bull market for the yellow stuff may be at an end. Now, I'm not so sure.
Ironically, a rising gold price may signify that the government's actions are working.
Gold has been skyrocketing on fear. I expect gold to fall off over the next few days as fear dissipates. However, the government's actions are very inflationary. If gold starts rising again, it may signal that inflation is re-entering the economy, and bad debts are being deflated away.
However, if gold continues falling, it may signal that the government's actions are fruitless, and that despite over $1 trillion thrown at the debacle, asset prices continue to fall. That would be very bad.
Possible broad restrictions on short-selling are a desperate measure, and even more so, a signal for investors to sell stocks. The hedge funds are massively short, but short restrictions do absolutely nothing to fix the problems in the economy.
The government is pondering this restriction to alleviate the pressures on the brokers, which they believe are under attack by the hedge funds. That may be, but why the government would restrict shorting, say, Microsoft (MSFT), is beyond me. I can understand restricting shorts on the brokers if the allegations about the hedge funds are true. But then, if the brokers are permanently impaired, a bounce from the restrictions would be a gift to the long-only funds to sell and would merely be a transfer of wealth from the shorts to the longs. If the models of the brokers are truly broken, restrictions on shorting will allow the longs to dump their positions, driving the stocks to zero anyways. It just may happen a little slower.
As I wrote this, Dow futures were up another 200 points. That would put the rally off yesterday's lows at 7%. I had been expecting a bounce, but I think much of the bounce may be finished.
I have been very short this market, and had planned to start covering a few percentage points below this week's lows. I do not think I will get the chance.
We are running into resistance, however. Much, if not all of this bounce is being driven by short-covering. RTC II and restrictions on short selling could provide a great bounce that merely allows sellers an opportunity to exit, thus setting up the next downleg and the re-test of prior lows.
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This article has 16 comments:
- investor88
- 600 Comments
Sep 19 10:59 AM- User 191801
- 2 Comments
Sep 19 11:36 AMExcellent piece. I agree with you that the markets are far from reaching a bottom. I am based in Asia and from what I've seen today, the surge was primarily attributed to short coverings. This will in fact set us up for the next downleg to re-test prior lows. I am inclined to think that the S&P500 may even hit 800, from its recent index price of around 1,150.
- Sean Maher
- 15 Comments
My Website
Sep 19 02:11 PM- jegan ;-)
- 697 Comments
Sep 19 04:05 PMTo that I say, Bush wants the Republicans to look like White Knights in time for the election. Too bad our financial network is failing simply because our president wants to wear another flack-jacket in November...
jegan ;-)
- Dame Daxx
- 34 Comments
Sep 19 09:05 PMThis time it's quite different. Financials have rallied, but Commodity Stocks were also up a lot today. This suggests that we're seeing not just some Sector Rotation, but New Money coming into the Market today.
I have much greater conviction in this Bottom than in the other 4 we're so far seen this year.
- investor88
- 600 Comments
Sep 19 09:54 PM- tudelson
- 16 Comments
Sep 20 01:04 AM- User 191801
- 2 Comments
Sep 20 04:18 AMI agree with your point about how the mechanics of the recent run-up on Friday Sept 19 could likey be due to new money, and not just short-covering.
And as much as I would like to hope that this is, in fact, the bottom, I can't help but notice the potential drop in corporate profits and economic forecast for the U.S., Europe and Asia.
My view is that Main Street has yet to experience the full negative impact of a financial melt down in Wall Street.
Similarly, developed and developing economies outside the U.S. have yet to experience that same ripple effect.
What partially drove the U.S. markets about a year ago was the assumption that the BRIC nations would propel and spearhead global consumption and growth. Although I am confident that the BRIC nations have solid fundamentals and are poised for long-term growth (7 to 10 years from today), the growth in many emerging economies have already begun to peak and are beginning to show signs of decline in the next year or two.
Moreover, even though portfolios and pensions have suffered severely, I think that total capitulation hasn't quite played out in recent events yet.
Thus, in light of the fact that global systemic risk has yet to fully materialize, I am inclined to agree with Toro that there unfortunately may be more downside and that this recent run-up is just a temporary bear rally.
- LA
- 12 Comments
Sep 20 09:05 AMInterestingly, if you look at Friday volumes for some ETFs, they are all much lower than Thursday. And a short selling ban is a desperate measure that could potentially increase instability, and not reduce it.
Most of all, whatever the plan is, it will do nothing to address falling consumer spending, falling housing prices, and higher unemployment. Banks are not going to rehire those who were laid-off over the past few months and manufacturers are not going to see a surge in demand. Ultimately, in my opinion this is why the market has been falling. The collapse of part of the banking system is only part of the bigger picture
- cashew
- 7 Comments
Sep 20 09:42 AM- cashew
- 7 Comments
Sep 20 09:44 AM- user1010101
- 4 Comments
Sep 20 12:08 PMAs for the enormous rise yesturday, it is a combination of short covering and new money.
The idea that the government will absorb the losses/defaults on credit and bad assets is only good news. After all, the government is the one entity with infinte access to capital.
Common people, speculation needs to end. Read some history!
- notsosmart
- 1086 Comments
Sep 20 03:28 PM- Duude
- 81 Comments
Sep 20 04:40 PMThe 90 day freeze turned into nearly 1,000 days of measures known as Phases One, Two, Three, and Four. The initial attempt to dampen inflation by calming inflationary expectations was a monumental failure when in 1974 inflation hit double digits. By this time they dropped these controls.
Lesson learned---in a free market economy, what seems like a prudent move is often later revealed to be ignorant.
- A J SESSA
- 5 Comments
My Website
Sep 20 05:37 PM- Baoinvestor
- 1 Comment
Sep 20 08:27 PMMore by Toro